The volatility of investor returns is higher than the corresponding volatility of buy-and-hold stock returns in almost all specifications.

According to professors at Emory University and University of British Columbia, this occurrence is primarily driven by the act of investors chasing stability but having bad timing. Additionally, the relative magnitude regarding the difference in volatility significantly varies, where the differential tends to increase with investment horizon.

For the study, NYSE/AMEX and Nasdaq data from 1925 to 2018 was used to create random portfolios of 10, 30 and 100 stocks. These portfolios were then tracked for returns over 10-year and 30-year horizons. For each portfolio, a random date within the available period was chosen and designated as the portfolio’s formation date. After randomly choosing stocks for the portfolios, dollar-weighted returns representing investor returns and buy-and-hold returns representing stock returns were calculated with respect to the portfolio’s composition. If a stock dropped out before the end of the investment horizon, a replacement stock was randomly chosen.

For every portfolio tested, the results showed that the volatility of dollar-weighted (investor) returns was higher than the volatility of buy-and-hold (stock) returns, with the differences being statistically significant. The volatility differential between buy-and-hold returns and dollar-weighted returns is economically large and increases considerably with investment horizon. According to the study’s authors, the dollar-weighted returns are about 15% to 20% more volatile for 10-year horizons, but the differential rises to 70% to 75% for the 30-year horizon.

Using the same procedures as for the portfolio tests, the study’s authors investigated potential drivers of the volatility of stock investor returns. The results from testing 1,000 portfolios with 30 stocks that are held for 30 years imply that investors tend to “flee volatility” and “chase stability,” but end up with bad timing with respect to stock volatility. Specifically, the researchers state that investors tend to add capital after periods with low volatility but before future high volatility occurs. The reverse pattern occurs for capital withdrawals. This chain of events leads to high exposure to stocks when volatility is high and low exposure to stocks when volatility is low, resulting in dollar-weighted returns having higher volatility than buy-and-hold returns.

Source: “The Volatility of Stock Investor Returns” by Ilia D. Dichev and Xin Zheng; SSRN, July 29, 2020.